The Case for More Drilling

Proponents of drilling more said gasoline prices would drop. Without government assistance, more drilling did take place – oh, baby, did we drill. Sure enough, natural gas prices dropped, but gasoline prices remained elevated. This conundrum is teaching us some important new lessons, which may shape how we proceed toward energy independence.

First, the nation is already energy independent in two sectors: electricity and natural gas. For the last decade, most of the nation's electricity has been produced from domestic sources, so there has been very little oil generating our electricity. The same is true with natural gas. With the recent drilling boom, most of the nation's natural gas is produced from domestic sources.

Most of the nation's drilling lessons came from natural gas. The first lesson was about infrastructure. Pipelines are needed to move products efficiently from wellheads to the market. If pipeline infrastructure is missing, producers are forced to discount prices and in the case of oil, they must use trucks, trains and barges to deliver their product to market. If the discounted prices are too low, producers will cap wells and wait for better prices.

Second, we learned that too much drilling can cause unacceptably low prices. Recently, natural gas prices fell to historically low levels. For many small producers, production costs exceeded market prices, causing them to suspend drilling. Baker Hughes (BHI) reports that rig counts for natural gas have fallen as more producers defer production and wait for higher prices.

Third, we found out that the markets worked, particularly for natural gas. As supplies grew against a sluggish demand, prices dropped. As natural gas prices dropped, the secondary market prices also dropped. As Exelon (EXC) points out, wholesale electric power prices are also dropping.

Independent power producers like Exelon, Capline (CPN), GenOn Energy (GEN), and NRG Energy (NRG) are finding wholesale prices falling as more natural gas is used as fuel. With lower wholesale prices, independent power producers are reporting their gross margins are challenged.

But natural gas is not gasoline. It turns out, more drilling did produce more petroleum. But unlike natural gas, more product did not lower gasoline prices. Gasoline is an entirely different commodity.

In addition, unlike natural gas, oil is an international commodity. As producers drilled for more oil, gasoline prices remain unchanged. It seems when more domestic oil is produced, more oil products are exported.

The Energy Information Administration (EIA) reports that last year, for the first time since 1949, the U.S. became a net exporter of oil products, including motor gasoline, diesel, and jet fuel. Taken together, these products have become the nation's second largest export.

The villain is the price spread between international oil prices. Brent crude is now priced much higher than U.S.-based West Texas Intermediate (WTI) crude. As long as this spread remains intact, it is more profitable for producers to export U.S. oil products than to serve domestic markets.

As long as the Brent-WTI spread remains intact, many U.S. refiners are motivated to export their products. Again, the markets are working. But in the case of oil, the international markets balance world supplies against demand.

From the perspective of U.S. consumers, more drilling may not lead to lower gasoline prices. But more drilling will provide more jobs, add to state and local tax bases and help balance international trade.